One Category of Mutual Fund to Avoid

One Category of Mutual Fund to Avoid

The basics of personal finance are pretty simple:

You spend less than you make. You use credit wisely. And you establish some type of emergency fund that can be easily accessed at any time.

Then, going forward, you put your new savings into investments that can grow your wealth more rapidly over time.

The harder part is figuring out the specific how’s, what’s, when’s and where’s.

Now as far as most investors are concerned, there are really only three basic investment categories — stocks, bonds, and cash.

Of course, there are also precious metals like gold and silver … as well as other so-called alternative assets like real estate and foreign currencies.

And with the ever-expanding universe of mutual funds and ETFs, accessing all corners of the investment world has never been easier.

So, the first and most important decision you face as an investor is not which specific investments to buy, it’s your asset allocation – i.e. what specific categories of investments you should buy and in what proportions.

As I’ll explain in a moment, Wall Street has a relatively new answer to this problem – one that I generally dislike.

But first, just to refresh your memory on asset allocation…

A traditional rule of thumb says to subtract your age from 100.

The resulting answer determines the percentage of stocks that should be in your portfolio.

For example, a 40-year-old investor would allocate 60% of his or her portfolio to equities.

The obvious idea here is that the longer you have until retirement, the more aggressive you should be.

Since stocks are historically more volatile — but also better able to outpace inflation over long periods — they deserve the lion’s share of a younger investor’s nest egg.

In contrast, bonds are considered better able to weather storms and kick off income, so they should comprise a higher percentage of an older investor’s portfolio.

Or at least that’s the traditional thinking.

Unfortunately, the one-size-fits-all approach isn’t perfect.

As you probably know, I don’t think bonds trump stocks either as income investments or as safe havens – especially not now.

So in my opinion older investors can dedicate larger portions of their portfolios to equities.

And again, these aren’t your only two choices.

So how much gold should you have?

Or how much real estate?

To further complicate matters, how much of an annual investment return do you need to meet your future goals?

Someone who has to make up for lost time will need to invest more aggressively than someone who has already achieved independence financially.

Last but not least, there’s your overall tolerance for risk.

Some folks — even 20-year-olds — just aren’t able to sleep at night when they’re sitting on a paper loss of 20% or 30%.

That’s fine.

But those people might be better off in ultra-conservative investments even if the standard rule of thumb suggests otherwise.

Sure, math and history might argue otherwise, but no amount of investment return is worth more than the ability to relax and enjoy life!

This is why so-called lifecycle funds can’t really solve the asset allocation question…

A whole new batch of mutual funds have come on the scene over the last few years and they are rapidly gaining prominence in employer-sponsored retirement plans.

These “lifecycle” mutual funds — which also go by names like “targeted funds” or “age-based” funds — promise to solve the issue of asset allocation in one fell swoop.


Well, lifecycle funds are “fund of funds.”

In other words, you buy one fund, but really own multiple mutual funds under that single banner.

So you simply decide when you plan on retiring, and let the lifecycle fund do the rest.

The fund’s manager will automatically determine what kind of asset allocation is appropriate for you and then spread your money into other funds that cover those areas.

Example: A 33-year-old investor might buy a lifecycle fund with a 2040 target date.

And right now, that fund might put 70% into a couple of different stock mutual funds and the other 30% into some bond mutual funds.

Then, as the years go by, the manager will gradually make the portfolio more conservative, by shifting money from the stock funds into the bond funds.

So by the time 2040 rolls around, the lifecycle fund will be primarily invested in bond funds and our now-60-year-old investor is ready to enjoy retirement.

But as I pointed out, there’s no way to lump an entire generation – or even two people of similar age – into one single asset allocation!

Moreover, even lifecycle funds with similar target dates can vary wildly in terms of their holdings.

Some managers are very conservative, even for far-off dates. Others might go hog wild on stocks.

There’s really no way to know without doing some due diligence.

And at that point, you might as well just assemble a list of funds or individual investments that suit your needs!

By the way, perhaps the biggest design feature of lifecycle funds is that they lead to nice fees and commissions for the companies that run them.

In fact, the beauty of this approach — from a fund company’s perspective — is that it virtually guarantees all of your assets stay “in house.”

It doesn’t matter if the fees are high or the individual fund performances are poor.

The concept encourages you to mindlessly pour your money into the same firm … and keep it there as long as you live!

Am I saying all lifecycle funds are bad?

Of course not.

You can find low-fee choices that might work well for you, especially if you don’t like picking individual investments or worrying about monitoring your asset allocation.

And I’d much rather see someone invest in an imperfect vehicle than not plan for retirement at all!

But in my opinion, you can do much better on your own. All it takes is a little self-examination using the big-picture questions I’ve already raised.

And even if you just tweak the basic rule of thumb method and use low-cost index funds, you’ll save yourself a lot of wasted money on mutual fund fees.

Bottom line: If you don’t currently have an overarching plan for your portfolio, please take an hour or two and figure out what your current asset allocation is … and whether it’s really appropriate for your needs.

Doing this simple exercise is truly worth the minimal effort involved.

To a richer life,

Nilus Mattive

Nilus Mattive
Editor, Rich Life Roadmap

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Nilus Mattive

Nilus is the editor for the daily e-letter The Rich Life Roadmap and a Paradigm Press analyst.

Nilus began his professional career at Jono Steinberg’s Individual Investor Group, where he published his original research through a regular investment column. Later, he worked for a private equity business and spent five years editing Standard and Poor’s...

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